The Gains from Trade: Production Possibilities
Problem of “What to produce”?
An economy has limited resources and wants are unlimited. Wants are satisfied by goods and services which are to be produced with the help of resources, so all goods and services cannot be produced. The economy has to decide which goods are to be produced.
Problem of “For whom to produce”?
Good and services are produced specifically for the people who can purchase them. Purchasing power depends on the distribution of National among factors of Production. The problem amounts to how the National Product is to be distributed among the people. It means who should get how much of the total amount of goods and services. Those have the larger income would have larger capacity to buy and hence will get larger amount of goods. People with different incomes will demand different goods. Therefore the guiding principle of how much to be produced depends on people with different purchasing power.
Problem of “What to produce”?
Since resources are limited all goods and services desired cannot be produced. If more resources are used for producing one good then fewer resources are left for producing other goods. Production Possibility is the Production Possibility Curve. All points on the curve represents all possible combination of goods (A&B) that can be produced with the given resources. Which combination to choose is the problem of “what to produce”. Let’s analyze with a simple example where there are two goods traded. Let’s consider wheat and rice produced by two farmers, one wheat farmer and one rice farmer, living in different states of a country.
The potential gains from trade are best illustrated when each farmer can only produce one good such as
- The wheat farmer can only produce wheat and
- The rice farmer can only produce rice.
While the wheat farmer enjoys wheat and the rice farmer enjoys rice. The gains from trading with each other are obvious, as both the farmers can gain from trading with each other. However, what if both farmers can produce both wheat and rice. Let’s use an example to consider how to look at this.
The wheat farmer and rice farmer
Supposing that each farmer works 10 hours per day, and they can produce both goods, but in different quantities as
Wheat farmer 1 hour/kg 0.25 hour/kg
Rice farmer 0.25 hour/kg 0.2 hour/kg
Wheat farmer 10 kg 40 kg
Rice farmer 40 kg 50 kg
We can see that the rice farmer has higher rate of productivity in both rice and wheat, and therefore has a PPF that allows production possibilities that the wheat farmer cannot achieve. Given the rice farmer is more productive in both goods, is there any reason for him to trade with wheat farmer?
Absolute advantage occurs when one producer has the ability to produce the same quantity of goods as another producing using fewer inputs.
In the previous example we saw that the rice farmer had an absolute advantage in production of both rice and wheat. So while absolute advantage is interesting to know about, by itself it is not enough how and why trade occurs. What we need to understand is the role of opportunity cost and comparative advantage.
Comparative advantage, opportunity cost and international trade
Recalling, the definition of opportunity cost is whatever must be given up to obtain something.
We can look at the previous example in a different way:
1 kg of Wheat 1kg of Rice
Wheat farmer 4 kg of chicken 0.25 kg of rice
Rice farmer 1.2 kg of chicken 0.83 kg of rice
With the table in mind, comparative advantage is defined as;
Comparative advantage is the ability to produce a good or services at a lower opportunity cost than other producer. The concept of opportunity cost and comparative advantage are what the amount of gains from trade that exits. That is to say, if producers face the same opportunity costs, there is no obvious gains from trade.